A historically reliable recession indicator has been flashing a warning since last summer, and it’s only getting louder.
- The yield curve has been inverted since July, a signal of an impending recession.
- Historically, when the yield curve inverts, a recession almost always follows.
- Some economists think this inversion may be different because it was caused by the pandemic.
Ever since July, 2-year Treasurys have offered higher yields than 10-year ones. Last month the spread between them opened to the widest margin since 1981, and it’s hovered near there ever since. In the past when shorter-term securities offered higher yields, a recession was imminent, as the chart below shows.
An inverted yield curve is an abnormal state of affairs that traditionally indicates something is wrong in the economy. In normal times, bonds with longer maturities have higher yields than those with shorter terms because investors want to be compensated for the uncertainty of a longer-term investment. When the opposite is true, it indicates that investors are betting on a downturn in the near future.
“When long rates fall below short term yields, that has historically been a fairly good guide to recession risks ahead, better, it’s often noted, than the track record of my own economics profession,” Avery Shenfeld, chief economist at CIBC Capital Markets, wrote in a commentary last week. “The only recession it failed to clearly signal was the 2020 COVID shock, which came on too suddenly, and from a non-economic source.”
Granted, that association is true until it isn’t. Economists at Goldman Sachs made the case in a research note Wednesday that this time might be different, and that the unusual economic circumstances brought about by the pandemic may have negated the yield curve’s predictive powers.
Nevertheless, the ongoing yield curve inversion is one indicator of many that the economy is slowing down because of the Federal Reserve’s anti-inflation interest rate hikes, and could enter a recession soon. Economists at Goldman Sachs recently pegged the odds of a recession at 25% in the next year, while a Bloomberg survey of economists put the chances at 65%.